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International Finance and Monetary Policy

Periodic Reporting for period 3 - INFIMOP (International Finance and Monetary Policy)

Reporting period: 2019-09-01 to 2021-02-28

How do financial globalization, monetary policies and financial stability interact? This project studies the international transmission channels of monetary policy from the main financial centres to the rest of the world and the ability of countries to conduct independent monetary policy in a financially integrated world. It uncovers the existence of a global financial cycle characterised by the co-movements of capital flows, risky asset prices and credit creation around the world. It shows that this global financial cycle is driven in part by US monetary policy. It analyses the role of financial intermediaries in transmitting monetary conditions in and across countries as well as their heterogenous propensities to take risk at certain points of the financial cycle.The links between monetary policy and systemic risk are of particular interest and are studied both theoretically and empirically using cutting-edge empirical methodologies.

Financial crises are some of the most costly episodes for economic well being as well as terrible periods for the social fabric of our countries. They may also lead to political crises. It is therefore of first order importance to understand better credit booms and busts which historically have been found to be at the origin of many financial crises. Having a better understanding of these large macroeconomic events should help us to avoid or at least mitigate their effects. The overall objectives of this project is to provide a scientific understanding of these phenomena in order to inform both macroeconomic stabilitization policies and macro prudential policies. Macro prudential policies are a relatively recent set of tools whose effectiveness can be greatly improved by a better understanding of the causes and channels of transmission of financial crises.
In “US monetary policy and the global financial cycle” (Miranda-Agrippino and Rey (2018)) we show that US monetary policy shocks induce co-movements in the international financial variables that characterize the “Global Financial Cycle” a concept introduced in Rey (2013). One global factor explaining an important share of the variation of risky asset prices around the world decreases significantly after a US monetary contraction. Monetary tightening in the US leads to significant deleveraging of global financial intermediaries, a decline in the provision of domestic credit globally, strong retrenchments of international credit flows, and tightening of foreign financial conditions. Countries with floating exchange rate regimes are subject to similar financial spillovers.
In “International Channels of Transmission of Monetary Policy and the Mundellian Trilemma” (2016), I show that US monetary policy shocks are transmitted internationally and affect financial conditions even in inflation targeting economies with large financial markets. Hence flexible exchange rates are not enough to guarantee monetary autonomy in a world of large capital flows. I perform the analysis for Canada, Sweden, New Zealand and the UK, which are all advanced economies having adopted inflation targeting regimes (and flexible exchange rates) as their policy framework.
In "Monetary policy on the Capitals of Capital” (Gerko and Rey (2017)) we analyse the transmission of monetary policy in two important financial centres, the United States and the United Kingdom. Studying the responses of mortgage and corporate spreads, we find evidence in favour of an important financial channel in both countries. Our identification strategy allows us to study the effect of movements in the policy instruments and forward guidance, broadly defined. We also analyse international financial spillovers, which we find to be asymmetric.
In “Financial Cycles with Heterogenous Intermediaries” (Coimbra and Rey (2018)) we develop a dynamic macroeconomic model with financial intermediaries with different degrees of risk taking ability and endogenous entry. It features time-varying endogenous macroeconomic risk that arises from the risk-shifting behaviour of financial intermediaries. We show that when interest rates are high, a decrease in interest rates stimulates investment and increases financial stability. In contrast, when interest rates are low, further stimulus can increase systemic risk and induce a fall in the risk premium through increased risk-shifting. In this case, the monetary authority faces a trade-off between stimulating the economy and financial stability.
In my work on “US monetary policy and the global financial cycle”, I made use of three unconventional methodologies. A) I used a dynamic factor model to test for the number of global factors in international asset price data and to estimate them. B) I used a proxy VAR with high frequency instruments (changes in Fed Funds Futures around FOMC meetings) to identify monetary policy shocks. C) I used an information rich Bayesian VAR which allows, I believe for the first time, the joint analysis of financial, monetary and real variables, in the US and abroad. This allowed me to characterise the "global financial cycle" and to uncovering of its important determinant.
In my work on “Monetary policy on the Capitals of Capital”, we construct a new set of instruments based on high frequency transaction price data on sterling futures to proxy for UK monetary policy shocks. This allowed me to characterise the financial spillovers between the US and the UK (in both directions).
In my work on “Financial Cycles with Heterogeneous Intermediaries”, we develop a new macroeconomic model allowing for different risk taking abilities for intermediaries. Unlike the existing literature this generates a dynamic distribution of intermediaries of different size and riskiness. We then have to solve a difficult problem to aggregate back these different actors and describe the macroeconomic implications. It is however key to allow for this heterogeneity to understand the data: some large banks like were very leveraged during the 2003-2007 run up to the crisis. This allowed me to characterise the links between monetary policy and systemic risk.

I intend to build on these results:
First, I will look in more detail at the international transmission of monetary policy using very detailed microeconomic data for some emerging markets. Second I will keep on developing the theoretical framework on financial cycles and heterogeneous intermediaries, exploring time varying distributions of leverage in the data and drawing implications for financial stability. Third, I will also introduce a very robust approach for crisis prediction that can help inform the theory further. Fourth, I will draw on my empirical findings on the global financial cycle to better understand the role of the hegemony in the international monetary system.
Helene Rey